Thus, the price-specie flow mechanism of the gold standard could automatically reduce current account surpluses and deficits, achieving a measure of external balance for all countries. In a reserve currency system, another country’s currency takes the role that gold played in a gold standard. In other words, a country fixes its own currency value to a unit of another country’s currency. If Britain decided to fix its currency to the dollar at the exchange rate E$/£ = 1.50 and in order to maintain this fixed exchange rate, the Bank of England would stand ready to exchange pounds for dollars (or dollars for pounds) on demand at the specified exchange rate. To accomplish this, the Bank of England would need to hold dollars on reserve in case there was ever any excess demand for dollars in exchange for pounds on the foreign exchange.
Initially, the equilibrium price of